Twin Cities Office, Industrial Markets Showed Signs Of Improving Health During The Second Half Of 2003 Small-to-mid-sized transactions fuel 1.1 million sq. ft. of positive absorption in industrial Surviving companies positioned for growth Movement of jobs overseas may impact commercial real estate market in next 12-18 months After a three-year slide, the Twin Cities industrial and office real estate markets are showing the first signs of recovery. Click here to read Boyd Stofer's perspective on the market Demand for Twin Cities industrial space increased significantly over the second half to 1.1 million square feet of positive absorption, led by a surge in leasing transactions for small to mid-sized quantities of space – in the range of 20,000 to 40,000 sq. ft. New demand for space is spread across a wide variety of industries, with small to mid-size companies outnumbering larger companies in demand for space at this early stage of the commercial markets recovery. Companies that have survived the economic downturn are now in strong position to grow as the conditions improve. While some larger companies may have excess space under lease that they must fill first before re-entering the market for direct space, small to mid-size companies that have become more lean and grown more financially fit through the downturn will need to add space as their business expands. Three of the region’s four industrial submarkets showed positive absorption gains in the second half, led by the Northeast submarket’s positive absorption of 469,840 sq. ft.. Business conditions are improving the quickest in the Northwest submarket, which saw positive absorption of 510,428 sq. ft. for the year. The Northwest also showed the lowest year-end vacancy rate among the submarkets, at 11% for direct space, 13.6% including sublease space. Overall vacancy for the Twin Cities industrial market stood at 15.2%/17% at year-end, down slightly from the mid-year totals of 15.9%/17.8%. Rental rates remained under downward pressure. Sublease space continues to be a competitive factor in the market, but the pace by which sublease is being returned to the market is fast diminishing. Steady demand for single-user buildings, fueled by low interest rates and an abundant supply of properties, also continues to undercut the market for multitenant space. Demand For Office Space Returning Signs are pointing to the beginning of a multi-year recovery in the Twin Cities office market. Positive absorption was reported in five submarkets throughout the Twin Cities including the Minneapolis CBD. Even so, office landlords confronted one of the most challenging markets in more than a decade. Metro-wide average vacancy rates climbed slightly higher, to 18.9%/21.6%. Rental rates remained under downward pressure, declining to an average $11.68 per square foot from the mid-year mark of $11.91, with concessions widely in use. Stronger demand for space in several submarkets was offset by a sharp rise in negative absorption in the St. Paul CBD. Second half absorption in downtown St. Paul was negative 490,344 sq. ft., with much of the drop linked to ongoing corporate consolidation by Conseco and US Bancorp. Vacancy also increased substantially in the St. Paul CBD, from 20.1%/21.2% at mid-year to 26.8/29% at year-end. Showing positive signs was the Minneapolis CBD, which recorded positive second half absorption of 122,515 sq. ft. – including positive absorption of 179,275 sq. ft. among Class A properties. Second-half vacancy in the 26 million sq. ft. Minneapolis CBD landed at 20.1%/23.1%, slightly lower than the mid-year mark of 20.2%/23.7%. Vacancy also declined in the Southwest submarket, from 17.3%/20.4% at mid-year to 17%/19.6% at year-end. A demand for Class A space in the region’s second largest submarket lifted the Southwest’s absorption numbers to positive 5,027 sq. ft. Overall, the market recorded negative absorption of 194,551 sq. ft. in the second half, compared to negative absorption of 654,473 sq. ft. at mid-year. Available sublease space remained virtually unchanged, at slightly less than 1.9 million sq. ft. throughout the market. Some tenants are taking advantage of the current ebb in rates and abundant space options to upgrade to better space, including a movement from Class B to Class A space. St. Paul CBD Stung By Ongoing Corporate Consolidation Corporate consolidation and retrenchment among large multitenant space users has mostly run its course, with the exception of ongoing consolidation by companies such as Conseco and US Bancorp in the St. Paul CBD. Corporate consolidation came at an inopportune time for the Twin Cities multitenant market, resulting in a net reduction in demand for office space amounting to as much as five million square feet – or approximately 40 percent of the current vacancy – over the past three years. Conditions will continue to be especially challenging for landlords in the St. Paul CBD in 2004. Corporate consolidation activity remains a major factor in the submarket, with companies continuing to pull back from the multitenant market. The State of Minnesota will also consolidate out of several hundred thousand square feet of multitenant space over the next few years as it completes construction work on four new state owned office buildings. Both the Minneapolis and St. Paul CBDs are courting Allina Hospitals and Clinics, a major healthcare organization in search of a 200,000 sq. ft. corporate headquarters location. Retail Market Fueled By Strong Demand, New Development The Twin Cities retail market continued to flourish, recording positive second half absorption of 1.87 million sq. ft. New construction added 2.2 million sq. ft. of space to the Twin Cities retail real estate market in 2003. Since 2000, the Twin Cities has absorbed more than 8 million sq. ft. of retail space. Retail landlords in the Twin Cities are faring even better than their counterparts nationally, with a metrowide vacancy rate of 5% for all types of retail properties versus the national rate of 6.8%. Regional malls reported the lowest vacancy rate, at 2.3%. Community centers were second lowest with a 3.3% vacancy rate. Neighborhood centers edged down slightly from their mid-year mark of 7.7% to 7.3%. Specialty centers saw a sudden increase in vacancy from 1.6% to 7.5%, almost all of which was due to the new 400,000 sq. ft. Shoppes at Arbor Lakes specialty/lifestyle center in Maple Grove coming onto the market not fully leased. Retail vacancy increased to 12.7% in the Minneapolis CBD, and was still high in the St. Paul CBD at 23%. Soaring vacancy rates in the CBD office markets mean fewer workers available to support downtown retail. Rapid residential growth is occurring in both cities’ CBDs, however, fueling optimism for the future of retailing in both areas. Some observers believe that the Minneapolis CBD will see a major grocer enter the submarket sometime in the near future, now that the downtown residential population has grown to include more than 30,000 people. National and international retailers continue to circle the Twin Cities market for locations including grocers, home improvement centers and pharmacies. Swedish home furnishings retailer Ikea is building a stand-alone superstore adjacent to the Mall of America in Bloomington. Restaurant companies also continued to flock to the Twin Cities in 2003, including Qdoba Mexican Grill, Bear Rock Café, Potbelly Sandwich Works and Pancheros. Most of the new retail construction in 2003 occurred in the fast-growing outer-ring suburbs such as Blaine, Lakeville, Savage, Shakopee, Maple Grove, Coon Rapids and Woodbury. Strong residential growth in those and other areas has spurred development of community and neighborhood shopping centers. SuperTargets anchored the year’s three largest new retail developments, in Champlin, Blaine and Savage. Investors Still on the Hunt for Grocery-Anchored Retail Investor demand for properties is strong, with grocery-anchored retail centers attracting the most interest. Sellers are taking advantage of the high demand and low capitalization rates prevalent for grocery-anchored retail to sell their properties. Buyer interest is also growing for a wider variety of retail centers, including non-anchored neighborhood and community centers. As many as nine community centers may be sold in the first half of 2004, based on information available at year-end 2003. Industrial properties, especially bulk warehouse and office warehouse, are also seeing increased demand. Good quality, stabilized office buildings with strong occupancy levels and creditworthy tenants are continuing to attract interest. Investors willing to assume a greater degree of risk are taking a closer look at the office properties facing more significant market challenges, such as low occupancy levels and deferred maintenance costs. In the multifamily market, several unusually large transactions occurred during the year, including Principal Financial’s purchase of two Plymouth apartment complexes totaling 570 units from the Sand Companies THE OUTLOOK  Wal-Mart continues to make inroads in the Twin Cities with the addition of new Wal-Mart and Sam’s Club outlets, while moving ever closer to the area with its Wal-Mart Supercenter concept as well. The company will likely debut a Wal-Mart Supercenter in the Twin Cities sometime in the next three to four years. Wal-Mart is also acquiring additional land near its current stores for possible future expansion, and exploring options for leasing space in existing retail centers – including some existing grocery-anchored community centers. Developers will not be as active in bringing new retail properties online in 2004, although Cub Foods, Target, SuperTarget, Wal-Mart, J.C. Penney, Sears, Costco and Lowe’s are all exploring new development plans for the Twin Cities. Regional malls may be adding a new concepts to bring in traffic in the form of non-traditional mall tenants such as laser surgery centers and even a home improvement retailer. Office landlords will face increased competitive pressures in 2004, even as demand returns. Tenants entering the market for new space will find an abundant number of options available to them, both in direct space and in the sublease market. Speculative development of new office buildings is not expected to return until 2005 at the earliest, even though developers continue to draw up preliminary plans for new construction. At least one company may be preparing to embark on a significant build-to-suit office project in 2004 of 100,000 sq. ft. or more. Improving demand for industrial space may result in a tightening of the market by mid-year 2004, with an easing of competitive pressures on landlords. Industrial development activity is expected to be slow in 2004. Developers are stockpiling land in anticipation of increasing business expansion over the next several years. The next wave of new industrial development will be focused on the outer-ring suburbs and beyond, as the amount of available land within the developed core of the Twin Cities is greatly reduced. Several Major Industrial Transactions are Likely to Take Place  in the First Half of 2004 There are concerns about the structural changes that have reshaped the American economy over the past few years. Corporate America has made vast improvements in productivity while also accelerating the trend of outsourcing service and manufacturing sector jobs to cheaper labor markets overseas. Forrester Research has estimated that over the next 15 years, some 3.3 million U.S. services industry jobs will be moved overseas. Even now, some have said that the so-called “jobless recovery” of 2002/2003 is a misnomer, and that in fact American industry has created millions of jobs over that time period – in other countries. Whatever the situation with off shore outsourcing, the fact remains that strong growth is a pre-requisite for full recovery in the Twin Cities office, industrial and multifamily markets.